In addition to limiting non- systematic risk, one of the goals of creating a diversified portfolio is to provide a more consistent return year in and year out. In the long run, consistency provides a greater profit than you’d achieve fluctuating between some stellar years and some black holes.
Diversifying means buying a number of investments within an asset class. No matter how good a blueprint is, it doesn’t guarantee high-quality results. You also need superior construction. In investment terms, this means building your portfolio by selecting a diversified group of securities for each asset class you invest in and ensuring that each security meets your criteria for investing. For example, if US equities are one of your asset classes, you might choose a number of individual stocks. Or you might diversify by choosing a variety of mutual funds or exchange-traded funds (ETFs) investing in US equities. Diversification within each asset class is essential because it allows you to offset, or dilute, security-specific risks.
You can expect securities that share similar characteristics to react in much the same way to specific factors or situations. For example, one of the major determinants of the value of any long- term corporate bond is its credit rating. With a downgrade, its value drops, and with an upgrade, its value increases. One of the key factors that affects the value of a stock is the quality of the company’s management. Some companies have exceptional management and, as a result, tend to outperform their peers, while other have inferior management and may falter even though they may be producing similar products or providing similar services.
The possibility of a downgrade in a long-term corporate bond’s rating that dramatically reduces a bond’s return represents a significant source of risk. Compounding the problem, it’s hard to predict when the credit quality of a particular bond will change. While this risk is significant with any single bond, you can reduce your overall risk by buying an assortment of similar bonds.
Contributions from the book Understanding Asset Allocation in this press release are used with permission from Light Bulb Press.